In July 2012, amid a backdrop of serious uncertainty over the future of the euro, ECB President Mario Draghi told the world that the central bank would “do whatever it takes” to save the currency.Prior to that point, the biggest open question was whether the ECB – which was seen as the only institution with the means to quell investor fears, yet was also perhaps legally or politically constrained from doing so – would step forward and put its weight behind a solution to the turmoil in European sovereign debt markets.
Draghi’s speech in July did just that. Since then, volatility has been crushed, high peripheral government bond yields that were seen as a threat to government stability have marched steadily lower as investors buy up Spanish and Italian debt, and stock markets have headed higher – after all, no one can find a reason to sell.
In a note yesterday addressing eurozone bond markets, titled “Now We’re Getting Worried,” Morgan Stanley strategist Laurence Mutkin explained the fundamental shift in sentiment among eurozone investors like this (emphasis added):
The “Whatever-It-Takes” speech created a seismic shift in market participants’ perceptions. Until then, each new obstacle provoked the question “will this break up the euro area?” Now, each obstacle raises the question “what steps will the authorities take to fix this?”
Patrick Artus, Chief Economist of the French investment bank Natixis, says all of the faith investors have placed in Draghi is misguided.
In a note, Artus compared the “Draghi put” that has emerged in financial markets since the speech in July to the “Greenspan put” U.S. investors began to count on in the 1990s, before the tech bubble burst at the end of that decade.
The concept of the “Greenspan put” is simple: in the 1990s, investors began to think there was no risk to investing in risky assets because if markets really went sour, then-Federal Reserve Chairman Alan Greenspan would step in and provide ample monetary accommodation, averting a crash or a crisis.
Everyone knows how that story ended – with the bursting of the dot-com bubble.
The rise in all financial asset prices in the euro zone (peripheral government in the euro zone bonds, European equities, bank bonds) is currently explained by the emergence of a “Draghi put.”
Investors are now convinced that thanks to the creation of the OMT, the ECB would react drastically and instantaneously to any event of rising interest rates and a recurrent crisis in the euro zone.
Euro-zone assets are therefore deemed to be risk-free, thanks to the “Draghi put”, despite the poor economic state of the euro zone excluding Germany: declining activity and investment, a fall in industrial production capacity and therefore in supply capacity in the future, political and social risk due to the rise in unemployment, major problems in reducing fiscal deficits and stabilising public debt, rise in defaults and deterioration in the banks’ solvency.
Past experience shows that a central bank cannot prevent an asset price bubble from bursting, even by switching to a very expansionary monetary policy.
Accordingly, there is no more effective “Draghi Put” today than there was an effective “Greenspan put” in 2000-2001.
This is all the more true as:
- The ECB’s monetary policy is already very expansionary;
- The risk of moral hazard would prevent the ECB from buying large amounts of government bonds.
The comparison provides an interesting thought experiment for European investors, especially given how astounding and far-reaching the Draghi rally has been.
The chart below shows the size of the Greenspan Fed’s response to the bursting of the tech bubble in the context of its previous policy actions. When markets crashed, the Fed slashed interest rates:
What is perhaps most interesting is that the crash in markets at the end of the tech bubble was preceded by a phase where the Fed was tightening monetary policy by raising interest rates.
Most consider recent developments in Europe – the ECB made clear in January that it is forgoing further rate cuts at this stage, and now banks are paying back loans to the ECB, which is also sending short-term rates higher – to amount to a de facto tightening.
That’s why Morgan Stanley’s Mutkin says it will be crucial to observe Draghi’s response to the upward move in rates since the last meeting.
Meanwhile, it’s probably good to keep in mind that markets have been in this situation before.